Asset Protection Attorney Alert:
Have you ever loaned money to your own company? Have you ever loaned money from one company to another? Do you have written loan agreements in place? Do your accounting records properly document the amount owed, transfers made, regular payments, and accruals of interest? Courts are coming down on these types of arrangements.
It is all too familiar to see when it comes to small and closely held businesses. The owner puts some of his or her own personal funds into a company or transfers money from one company to the other to cover expenses for that company. Most owners don’t think twice about it since they don’t have many other shareholders to consider or seek approval from. Rarely do we see clients who come in who have entered into those kinds of deals that present documented loan agreements or any kind of records, but they think “it’s my company, so it doesn’t really matter” or “I am not publicly traded with the SEC or a big board of directors watching, so who cares.” What they may not realize is that it can end up hurting the company or the shareholder down the road and, in some cases, in a pretty drastic fashion.
Several recent court cases have emphasized just how much not documenting loans can hurt a company. Most of these arise in the bankruptcy context, but can be applied to regular state law claims related to loans, which can affect nearly anyone. Even a minority shareholder could try to use these principles to his or her advantage to avoid loans the company owes to a majority shareholder.
The cases involve an extension of the bankruptcy court’s powers when it comes to debts. A bankruptcy court has broad equitable powers under Section 105 of the Bankruptcy Code to make changes to carry out a bankruptcy. On March 4, 2014, the US Supreme Court in Law v. Siegel issued an opinion that put a few restrictions on the recent expansion of those powers, but the concerns for business owners are still there and it is clear that the bankruptcy court’s use of those powers is still valid.
Since this ruling, a bankruptcy appeals panel has held that Law v. Siegel does not go so far as to ban a bankruptcy judge from recharacterizing debt as equity, which is more relevant for business owners. The case of In Re: Alternate Fuels, Inc. was decided by the 10th Circuit Bankruptcy Appellate Panel on March 18, 2014 finding that loans by a shareholder to the company were equity and not a loan, despite the ruling in Law v. Siegel.
The facts of other recent cases are similar in that the court eventually converted what was claimed to be debts owed by the company to a shareholder/owner into equity. The shareholder would put money into a company and then claim the company was required to pay it back and make a claim in the bankruptcy court to get paid back. The courts have found that some of these so-called “debts” were really equity investments by the owner into the company with little to no value. In a bankruptcy liquidation, if there are assets available, the assets are distributed according to priority to certain liabilities and if all liabilities are paid, then what remains gets distributed to equity holders/owners. In a bankruptcy repayment or reorganization, such as is common in Chapter 11, the debt holders get paid off over time, but the equity holders do not receive payments. When the court says that someone with a debt really invested equity and converts it into equity, they are saying that in most cases, that person is out of luck and will probably not get anything.
The cases look to the elements reviewed by state courts when analyzing whether a transfer of an asset could be considered a fraudulent transfer to avoid creditors. If there is no transfer for something of reasonably equivalent value and there is no real obligation to pay the loan back, it could be considered fraudulent resulting in the loan not being allowed as a legitimate claim and an unwinding of the transaction. This could result in a company or shareholder loaning money to another company he or she owns and losing that money.
Additionally, these loans have an impact in the context of asset protection planning. For example, say John Q. Shareholder owns 2 LLCs: Bad Credit, LLC and Money Maker, LLC. Bad Credit, LLC defaults on some loans and gets sued by a bank. The bank gets a judgment against Bad Credit, LLC, but learns that Bad Credit, LLC would frequently pay for expenses of Money Maker, LLC. Mr. Shareholder saw nothing wrong with this and even used one bank account to receive income and pay expenses for both LLCs. The bank will go to court and try to collect against Money Maker, LLC and Bad Credit, LLC arguing that they are really not different companies due to the commingling (sharing) of assets. Mr. Shareholder will try to claim the expenses paid by Money Maker, LLC were just loans to Bad Credit, LLC, but when it comes time to prove they are loans, he fails. The court decides that the two LLCs with common ownership, similar bank account, and shared expenses are really just one company and the bank can go over both LLCs for the debt. Or even worse, the bank says that both LLCs are really nothing more than Shareholder’s alter ego and the bank can now collect against Shareholder personally.
So what can be done?
A court is more likely to find a valid and enforceable loan when there is a well drafted written loan agreement in place and it is actually treated like a real loan. This could be an inter-company loan agreement, promissory note, revolving credit line agreement, or other debt document. The loan has to be for reasonably equivalent value to what is being provided and actually have terms that could be enforced. If there are regular payments due, those must be paid and documented. If there is interest due (which there should be at least some minimum amount provided for), it should be regularly accrued and put on the company’s books or accounting records. These are just some of the actions that need to be taken to protect those dollars you lent to the company. The more a court would view the arrangement as similar to what a bank or some other outsider lending money would put into place, the more likely the court would enforce the loan or keep liabilities separated from the owner or other companies. It is also highly recommended to avoid commingling (sharing) funds or bank accounts between companies or owners, but I realize that the day to day needs of a company may not allow that kind of requirement to be kept. If you have an LLC or corporation, be sure you have a separate bank account in that company’s name and try not to run any personal expenses through it.
A little planning can avoid courts turning your loan into worthless equity or making your personal assets vulnerable to creditors. Avoid these situations altogether with valid legal loan agreements, documented accounting, and segregated accounts and funds, so business owner beware!